Fed tapering should help, not hurt, the dollar

The markets are obsessed with the Fed and Japan. But if Ben Bernanke does pull back on QE, that should boost the dollar.

The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, Abbott Laboratories and AbbVie, La Monica does not own positions in any individual stocks.

Taper taper taper. Yen yen yen. The world's financial markets are obsessed with just two things right now: the potential beginning of the end of the Federal Reserve's bond purchases and what Japan's currency is doing.

But that's created a lot of confusion for investors. Consider this. There's a lot of talk that the dollar is weakening against the yen (as well as the euro) because of concerns about the Fed cutting back, or "tapering" its quantitative easing program.

If you stop and think about it, that doesn't make a heck of a lot of sense. Fed chairman Ben Bernanke has been demonized by inflation hawks because of QE. Fed critics think that Bernanke has been willfully destroying the dollar by buying more and more bonds and mortgage-backed-securities. The current monthly tally for QE is now $85 billion of purchases every month.

The Bernanke-haters have a point. The value of the U.S. Dollar Index -- which tracks the greenback versus the yen, euro, British pound, Swedish krona, Swiss franc and Canadian dollar -- has fallen about 8% since the Fed launched the first QE back in November 2008.

So if the Fed is finally getting ready to pull back on these bond purchases, shouldn't the dollar go up?

"It is illogical. The dollar should already be reacting in a positive way but it isn't yet," said Guido Schulz, global head of strategic management at AFEX, an international payment solutions company in Encino, Calif. "It is a strange environment right now."

What may be going on is that the dollar is just collateral damage to what's going on in Japan. The yen had weakened dramatically earlier this year thanks to the new policies put in place by Prime Minister Shinzo Abe and the Bank of Japan (aka Abenomics) to help inflate the Japanese economy. But the absence of even more stimulus has spooked Japanese investors. The Nikkei has plunged into bear market territory as the yen has started to strengthen.

Simply put, the yen went down and Japanese stocks went up too far too fast. We're now seeing the proverbial day of reckoning. But you would have to think that at some point relatively soon, normalcy will return to the Japanese markets.

When that happens, investors will have to once again look at what's going on in the U.S. -- and that should lead to a stronger dollar.

Long-term bond rates have already started to rise in anticipation of Fed tapering. The yield on the 10-year Treasury is now hovering around 2.2%. While that's still low by historical standards, it's up dramatically from around 1.6% as recently as the start of May.

And currencies typically move in the same direction as bond rates. That's the way it should work for the longer-term at least.

"This looks very temporary and transitional to us. It does seem counterintuitive," said Brian Battle, director of Performance Trust Capital Partners, a fixed-income trading firm in Chicago.

Battle said that bond rates should continue to creep higher once the Fed finally makes its tapering plan official. He said there's even some vague rumors among bond traders about how the Fed could shock investors by announcing a slight pullback in its asset purchases -- to $75 billion a month -- as early as next week's policy meeting. If that happens, long-term rates should move even higher ... and it's hard to fathom how the dollar shouldn't follow suit.

"Yields have been trading up on the suspicion of tapering. I think bond traders would actually sell more on the fact," Battle said, referring to how rates go up when bond prices go down.

Battle conceded that the Fed probably won't pull back on QE next week. That does sound premature, especially since jobs growth has only averaged 189,000 a month so far this year. (And that number is skewed by the addition of 332,000 jobs in February.)

Still, it is getting harder to deny the obvious. The U.S. economy is getting better. The housing market has picked up. Consumers are still spending. Yes, it's merely a gradual expansion -- what I've been calling a low and slow barbecue recovery for three years. It would make us all feel better if the monthly jobs gains start to exceed 200,000 on a consistent basis.

But we're getting there.

"Growth should pick up a little bit and interest rates should inch up," said John Burke, CEO of Burke Financial Strategies, an advisory firm in Iselin, N.J.

And that means the Fed should finally take off the market's training wheels/remove the punchbowl/move the patient out of the ICU or whatever other metaphor you'd like to use to signify the unwinding of QE.

"Cheap money is coming to an end. In the long-term, the dollar should, at the very least, stabilize and maybe start to appreciate against the euro and yen. But it all depends on how the U.S. economy does," said Schulz.

Paul R. La Monica is an assistant managing editor at CNNMoney. He is the author of the site's daily column, The Buzz, and also tweets throughout the day about the markets and economy @LaMonicaBuzz. La Monica also oversees the site's economic, markets and technology coverage.